In our November Value Call, we’re featuring Brookfield Asset Management, a Dividend Bull List stock here at Stocktrades.
If you’ve been with us for any amount of time, you’ll probably remember that our Value Calls used to be 3 stocks a month, with a short write up on each. We’ve now transitioned to a single stock, with much more in-depth analysis.
Lets dive right into it.
November Value Call – Brookfield Asset Management (TSE:BAM)
It has been almost a year since Brookfield Asset Management split from Brookfield Corporation.
We found that the spinoff was confusing investors, and there was a valuation gap that existed for Brookfield Asset Management. This is why the company has been featured on our Dividend Bull List ever since.
Despite jumping off to a difficult start and losing double-digits post-spinoff, you might be surprised that BAM is outperforming the Index. Since it began trading independently, BAM has gained 6.90%, more than double that of the S&P/TSX Composite Index (3.42%).
It gets even better in 2023. The company has returned 21.3%, outperforming both the S&P 500 and the TSX.
It wasn’t always like that, but it appears investors are finally starting to warm up to the company. This is a good thing since the company is attractively valued in our opinion, and if market sentiment changes, then BAM investors are poised to benefit.
First off, let’s understand the business a little more
Brookfield has always been a rollup of very complex businesses. However, the asset management portion is probably one of the easiest ones to understand.
What does an asset manager do? As simply as we can put it, they manage investments for clients, such as stocks, bonds, real estate, or other types of assets.
You’ll see Brookfield and others talk about three key metrics for the company. If you have any interest in following the company, burn these metrics into your mind:
- Fee-related earnings (FRE)
- Distributable earnings (DRE)
- Fee-bearing capital (FBC)
All three play an important role in understanding and valuing the company, so let us explain all three before we get into company valuation.
FRE: Fee-related earnings for asset management companies are essentially the profits from the fees charged for managing assets. It is important to note that they represent the main sources of income for asset management companies.
For Brookfield, these are classified as base management fees, incentive distributions, performance fees, and transaction fees. Today, more than 90% of FRE at Brookfield are related to base management fees, the most stable and reliable earnings for asset managers.
DRE: Includes FRE and all other sources of earnings. This can include gains or losses on investments, interest and dividend income from other sources, and adjustments of non-cash items (such as amortization). According to BAM, DRE is the most comparable to net income for traditional companies.
FBC: Fee-bearing capital is the portion of the total assets under management (AUM) that is subject to management fees. Not all capital managed by asset managers may be fee-bearing; some might be managed without charging fees, especially when the company manages its own money or that of its employees. In effect, as FBC grows, so too does FRE. Ultimately, you want the company to be growing its fee-bearing capital.
Another term you might see is Fee-Related Revenue (FRR), which is directly related to FRE. As you might expect, it refers to the revenues Brookfield generates from base management fees, incentive distributions, performance fees and transaction fees.
The easy part for Brookfield investors is that DRE is made up almost entirely of FRE, which makes the two numbers almost interchangeable.
The bad news? The company’s most recent update indicated a slight change in strategy, which includes investing their own money in some of their funds. This means that FRE and DRE may not be so interchangeable in the future. To clarify, this is not necessarily bad from an operational perspective. It will just make FRE and DRE more disconnected.
NOTE: FRE and DRE per share are not the same as earnings per share (EPS). Regarding asset managers, FRE and DRE are the preferred valuation methods as they offer a more specific view of the cash earnings that can be distributed to shareholders in asset management and investment firms.
To illustrate, in Q3 BAM posted:
- EPS: US$0.31
- FRE per share: US$0.35
- DRE per share: US$0.35
If we lost you somewhere above, make sure to head to the Q&A and ask us your questions. This is probably one of the most key features you have access to here at Stocktrades.
Now that we know the basics let’s dig into valuations
Asset management companies are typically valued against FRE, a common industry practice. Don’t believe us? Then we will let Brookfield do the talking straight out of their annual report:
“Alternative asset management businesses such as ours are typically valued based on multiples of their Fee-Related Earnings and performance income. Accordingly, we create value by increasing the amount and quality of fee-related earnings and carried interest, net of associated costs. This growth is achieved primarily by expanding the amount of Fee-Bearing Capital we manage, earning performance income such as carried interest through superior investment results and maintaining competitive operating margins.”
Simply put, to increase company value, they focus on growing FRE, which depends on FBC and generating profit on successful investments.
This also means that most traditional valuation methods you see on websites like Yahoo Finance will not be effective with Brookfield Asset Management. In fact, it will likely end up just confusing you.
Before we get into number crunching, an important note: all publicly available data on BAM is still skewed since it has not been a full year since the spinoff. That means historical data and trailing twelve-month data are not reliable. As a result, you must go directly to company financials to get the relevant information you need.
Over the last twelve months, the company generated $2.236B in fee-related earnings (FRE) and $1.37 on a per-share basis. Since Brookfield reports in USD, the easiest way to get an appropriate multiple is to use BAM’s NYSE listing. Today, BAM trades at $33.97 per share, working out to be 24.79x its FRE.
The valuation gap is closing
Since our last quarterly update (which you can read here), BAM has narrowed the valuation gap. Previously, it was trading at 22.76x FRE, but it has since gained almost 20%. That said, it is still trading below where it was as of the end of Fiscal 2022 (25.1x FRE).
Furthermore, one of the best comparables for Brookfield is Blackstone, which trades on the NYSE under the symbol BX. Today, Blackstone trades at 29.7x FRE – a significant premium. This disconnect is unlikely to last, especially considering Brookfield has performed better operationally in Fiscal 2023.
For example, FRE at Brookfield has grown by 8% year-over-year (YoY) through the first nine months of the year, while Blackstone’s FRE is in negative territory and has frequently missed estimates.
According to Price Waterhouse Coopers (PWC), large multi-strategy asset managers typically trade for around 28-29x FRE.
At their annual update, Brookfield management indicated that they were targeting $1 Trillion in Fee Bearing Capital and to eclipse $5 billion in annual FRE by 2028. Last quarter, the company indicated they “project significant growth in their (FRE & DRE) in 2024.” This equals a five-year compound annual growth rate of 18% and is in line with their 20% historical growth rate.
In comparison, Blackstone is only expected to grow by mid-to-high single-digits annually. Considering all this, there is no reason why Brookfield shouldn’t be trading more closely with the averages of other large multi-strategy asset managers.
Since the spinoff, Brookfield traded at a low of ~20x FRE – let’s use this as our downside scenario. As mentioned, it is trading at ~25x FRE today, which we will use as our base case. As for the upside, we will use 29x FRE, which aligns more with where Blackstone is currently trading.
Based on the realistic assumption of 18% FRE growth – here is where BAM could be trading based on all three scenarios:
In the formulas below, the $1.37 is the FRE mentioned earlier in the article, the 1.18 represents 18% growth, and the 20,25, and 29 represent the multiple it could trade at in terms of FRE. Beside it is the potential share price upside/downside.
Bear Case: ($1.37 * 1.18) * 20 = $32.33 -4.82% downside
Base Case: ($1.37 * 1.18) * 25 = $40.42 18.98% upside
Bull Case: ($1.37 * 1.18) * 29 = $46.88 38.00% upside
As you can see, the risk-to-reward proposition is quite attractive here. Keep in mind we haven’t included the dividend calculation in this price, and today, BAM yields a respectable 3.77%.
Nor have we included or provided any value to non-FRE earnings (more on that in a bit). In the base case, a ~19% return is likely to outperform the market, and while it may seem like a stretch, the upside scenario is realistic, barring any type of positive market sentiment.
Carried interest – An important metric moving forward
If we circle back to Brookfield’s definition of DRE, you’ll notice that they include ”carried interest.” Carried interest is a form of compensation often used in the asset management industry, particularly in private equity and hedge funds.
It represents a share of the profits that the fund managers earn from the investment funds they manage. This is separate from the regular management fees that these firms charge.
As Brookfield defines it:
“Carried interest entitles (them) to a portion of overall fund profits, provided that investors receive a minimum prescribed preferred return.” It is usually paid towards the end of the fund’s lifecycle after capital has been returned to investors.
Why are we bringing this up now?
Part of the split with Brookfield Corp was that Brookfield was only allowed to earn carried interest on ”new” funds launched since the spinout. That means every new fund launched carried eligible capital.
The benefits won’t be immediate because, as mentioned, they get paid out near the end of the fund’s lifecycle. However, Brookfield lets us know how significant of an impact this could be:
“To give you a sense of the magnitude, in 2029 BAM is expected to realize approximately $2 billion of gross carried interest, which should grow to approximately $7 billion of annual gross carried interest realized by 2033. This gives us good line of sight on earnings growth for the next 10 years.”
Remember, carried interest is NOT included in the calculation of FRE. As such, if Brookfield hits these projections, DRE is likely going to add significant value.
Another attractive aspect is that Brookfield has a targeted dividend payout of 90% of DRE. Since DRE is relatively equal to FRE, we are likely to see the dividend grow in line with FRE, at minimum. This means investors can expect annual dividend growth in the mid-to-high teens.
All in all, we think that Brookfield Asset Management is quite attractive at these levels
Even though sentiment has turned positive over the past month, asset managers still see plenty of headwinds. As rates stabilize and positive sentiment returns, we believe that Brookfield is well-positioned to close the valuation gap between itself and their peers.
Dare we say it? Is Brookfield Asset Management a Triple Threat? If you have been with us for a while, you will know that these are our favourite types of stocks. To qualify as a “triple threat,” a company needs to be:
- Undervalued (which BAM has been since it was spun off)
- Considered a growth stock (growing the business by at least 10% annually)
- Have strong dividend growth (double digits)
Triple-threat stocks are hard to come by, but when we do find them, they tend to deliver. Over the years, we have tagged few companies with this distinction.
If you bought TFI International (TFII), goeasy (GSY), Canadian Natural Resources (TSE:CNQ), or Equitable Bank (EQB) when we first identified those as triple threats, you’d be sitting on hefty gains.
The only other one where we have made that distinction is Alimentation Couche-Tard (ATD), which was a short-lived opportunity. Many of us know how well that one panned out.
That said, we are tagging Brookfield Asset Management with that rare distinction – in our opinion, BAM is a triple threat.
